Minstar Acquiring Corp. v.AMF Incorporated 621 F.Supp. 1252 (1985)

Topic: Takeover DefensesBackground:

The subject of the conflict are two defensive options against takeovers. First, is the poison pill. Second, is the scorched earth tactic. In ruling for Minstar, the Court reasoned that the two defensive options worked against the interest of AMF’s shareholders. Now, the poison pill was held to be illegal—but only in this particular case. For scorched earth, the Court saw this as management entrenchment. The brief discussion of the two options in this background aims to show why the Court decided such.

Scorched Earth:

In tender offers, scorched earth occurs when defending directors purposefully injure the corporation. This is done by riddling the corporation with debt and exhausting its credit. The newly acquired corporation must service a long term debt which has no current value to the company, while it is unable to borrow the money it needs to function.

Here, AMF decided to amend the company's stock option and Long Term Incentive Plan. The original plan to granted to key employees favorable options to purchase stock based upon stated performance objectives. The amendment created favorable option prices derived from market events, rather than from employment based achievements. The plan expanded the definition of events for triggering the option to include the consummation of a tender offer.

Also the AMF board provided increased benefits under a previously terminated Retirement Annuity Plan. Another measure created the "Severance Allowance Plan" providing for an increase in the severance allowance for certain employees. These changes became operative only if a change of control occurs.

The Board established two trusts to implement the newly-developed plans. The first trust provided the resources for funding the increased retirement benefits. The second trust provided the resources to fund deferred payments under the Rights Plan. The provisions of the trusts provided for revocability by the incumbent Board but, in the event a new Board took control, the new Board would be irrevocably bound by the trusts.

Poison Pill:

AMF declared a dividend of one "Right" per share of its outstanding common stock, as of the close of business. Each Right entitled the holder to exchange one share of AMF common stock for a "unit" comprised of one-tenth of a share of a new series of AMF stock designated "Series B Preference Stock". The Indenture covering these Debentures contained certain restrictions including: (1) a moratorium on incurring further debt, except for working capital used in the ordinary course of business and to fund the Rights Plan; (2) a restriction on the sale or transfer of assets of AMF exceeding 1% of Consolidated Adjusted Net Assets, except as conducted in the ordinary course of business; and (3) a prohibition on the making of investments with affiliates of AMF.

The Rights assigned are not transferable and may be exercised only during a 40 day period beginning on the date that a person acquires 30% or more of the shares of AMF common

stock without having proposed a plan to acquire all the remaining shares on terms which are deemed fair by the board of directors. The Rights expires if not triggered on a certain date. In the event the Rights are exercised, the holders of Series B Preference Stock are entitled to receive dividends at an annual rate of 15.5% per share. The Series B Stock is not redeemable until 1990 and only at a specified premium. The Series B stockholders are not entitled to vote for directors, except if accrued dividends are not paid. In this event the B stock, as a class, may elect two members of the Board. The Rights are redeemable for $.10 per Right by action of the AMF board at any time prior to a change in control, however, upon a change in control they become irredeemable.

Facts:

Minstar commenced a tender offer against AMF; but this was preceded by a so-called "running start" whereby Minstar beneficially acquired about 7.5% of the outstanding AMF stock. If the offer succeeds Minstar will beneficially control about 50.5% of AMF stock. The AMF board met to consider the Minstar offer and unanimously rejected it. The alleged rationale for the rejection was that, taken as a whole, the offer was inadequate and not in the best interest of the corporation or its shareholders. At the AMF board meetings between May 2, 1985 and May 9, 1985 the Board considered and discussed the implementation of various defensive tactics designed to thwart the Minstar takeover bid. In its 14d-9 Schedule AMF unveiled a series of defensive tactics designed to prevent the takeover.

Issue:

AMF detested Minstar so much that it was ready to take a “poison pill” or use “scorched earth tactics”. Now, would the use of these defensive options constitute a “sound business plan”? Or would it be a breach of fiduciary duty or even ultra vires?

Held & Rationale:

On Poison Pill being Ultra Vires:

The Rights are not transferable. Thus, only the shareholders as of May 20, have any right to convert their stock. AMF contends that it did not discriminate against Minstar because, to the extent that Minstar owned any stock on May 20th, it too may convert. We find AMF's argument unpersuasive.

The May 20th date was not simply the record closing date as in the case of the usual dividends declaration. Normally, the record date closes the class of shareholders eligible to receive the dividend. Thereafter, the shareholder may transfer his dividend if he so chooses. The non-transferability of the Rights in the instant case is the fatal flaw.

A second ground for invalidating this Plan is that the non-transferability of the Rights constitutes an unreasonable restraint on the alienability of the underlying common stock. Under normal circumstances Rights have real value when exercised in conjunction with common stock. However, the transfer of the common stock herein cannot be accomplished with the Rights, thus the value of stock in the hands of a post-May 20th purchaser is significantly reduced. Moreover, the seller would destroy much of the value of the Right by transferring the stock. Under these circumstances we find that the non-transferability of the Right is an unreasonable restraint on alienation.

Finally we note the Rights Plan has the impermissible effect of vesting a veto power over any merger in the hands of the non-tendering May 20th stockholders. As discussed above only May 20th stockholders can become Class B shareholders. The Rights Plan requires approval of a merger by the Class B stock as a class, thus the May 20th shareholders may have effective control over any merger. The only way Minstar could ever merge would be to conduct a second tender offer after the Rights have been exercised to gain control of now non-existent Class B stock. We believe that such major changes in structure and voting rights may only be approved by the shareholders.

We simply hold that the debentures, with their restraints, were issued as part of the Rights Plan and thus are illegal. We will leave the question of whether similar debentures with similar restraints are in themselves invalid for another day.

Scorched Earth; Breach of Fiduciary Duty and Unsound Business Judgment:

As noted above we do not reach the question of whether the poison pill breached their fiduciary duty.

The business judgment rule is a rule of judicial restraint which holds that courts will not inquire into the business judgment of directors who are acting without self-interest and in good faith. As an initial matter we question whether it is appropriate to apply the rule in the context of defensive tactics. Questions like "should we buy a new truck today?" or "should we give Joe a raise?" are simplistically, types of business judgments which the rule was developed to protect. Courts have no place substituting their judgments for that of the directors.

Defensive tactics raise a wholly different set of considerations. Defensive tactics often, by their very nature, act as a restraint on business purposes. The application of the business judgment rule in this context seems, to us, questionable, however, the weight of authority dictates that the rule be applied.(Holding that the business judgment rule applies to tender offer defensive tactics. )

Under the facts of this case we believe that at least as strong an inference is raised. This inference is based upon the fact that the severance benefits, like the other defensive tactics, are triggered only by the change in control. Minstar points out that AMF has already announced a long term plan which calls for substantial staff reductions in some areas. Thus, an employee who is to be terminated pursuant to the Plan, will receive twice as many severance benefits, if Minstar takes over, even though the decision to terminate him was already made by the present AMF board. AMF claims the changes are "prudent steps designed for the most part to safeguard rights and benefits already earned by and owed to AMF employees". It goes on to argue that the increases were made to bring AMF in line with "severance plans in effect at other companies." If this was in fact the true justification then conditioning the program on a change in control would be unnecessary.

The time limit also tends to support the inference that the scorched earth tactics were intended only to thwart tender offers. If AMF's board's justification was to protect employees and the like, there would be no reason for the durational limitation.

Accordingly, we hold on the record before us that the conditioning of the various scorched earth tactics on a change in control of AMF properly raises a strong inference that AMF's

board acted only to entrench itself. This inference is sufficiently strong to shift the burden to the directors under the business judgment rule. Nothing in this holding should be read to say that the same type of severance benefits and employee rights would not be proper exercises of business judgment if granted, unconditioned on a change in control of the corporation.